Markets, States, and the Green Transition

To get renewable energy technologies into broad use, government needs to promote both supply and demand. Markets are too risk-averse.

(AP Photo/U.S. Army)

This solar array at White Sands, New Mexico, is the largest of the U.S. Army's solar photovoltaic systems. The $16.8 million project includes nearly 15,500 sun-tracking solar panels spread across 42 acres.

This article appears as part of a special report, "What the Free Market Can't Do," in the Winter 2015 issue of The American Prospect magazine. Subscribe here.

If you believe in the perfect efficiency of free markets, then any government intervention, by definition, has to make things worse. Evidence is of no consequence. I once participated in a debate on innovation with two panelists from two of Washington’s most market-oriented think tanks. When I pointed out that a government program—the Department of Defense’s Advanced Research Projects Agency (DARPA)—had created the Internet, my opponent was hardly fazed. He responded, in effect, by saying we don’t know whether the private sector might have done it faster and better had the government not been interfering. Of course, we cannot know, but the historical experience of many other technologies that were accelerated by spending on warfare suggests that there is a strong connection between government investments and big technological breakthroughs. World War II alone was responsible for jet airplanes, the mainframe computer, radar, atomic energy, and it laid the groundwork for much of the space program that followed.

War and preparation for war loom so large for many breakthroughs because war offers the rare occasion for major government intervention in a society that otherwise professes belief in free markets. Ideology is waived because of the presumed urgency of national defense, and surprising technical breakthroughs often follow. Government needs to play the same role in the transition to a green economy.

In wartime, government action is so potent because it intervenes simultaneously by increasing both the supply and the demand for new technologies. As with the Manhattan Project, the military convenes large groups of scientists and gives them substantial resources, to see if a concept can actually be turned into something that adds to the military’s capacity. Then the military orders a lot of the new creation, so that the often slow and painful process of scaling up to mass production is done very quickly with no risk for private firms.

This double-sided process jumps over the huge hurdles that private businesses face in developing radical new technologies. Since uncertainty is invariably high, most firms are reluctant to pay for years of expensive development work on a new technology. Even once they get what engineers call “proof of concept,” entrepreneurs know that it might take another ten years to figure out how to mass-produce the good. The most enthusiastic entrepreneur still has to worry about a firm’s survival through the very long and expensive development period when their new product is generating zero revenue. And these fears are intensified when it is also unclear whether anyone is going to buy their breakthrough product.

This is the reason that in virtually every country, including the United States, governments are now actively involved in helping private firms with the process of technological innovation. Mariana Mazzucato has drawn attention to this public sector role by titling her recent book The Entrepreneurial State. She shows that without the state taking a significant part of the risk, there would be much slower rates of technological innovation around the world.

This under-appreciated state involvement is true of many new technologies and sectors, but it emphatically describes the necessary transition to renewable energy. Private entrepreneurs contemplating investment in green energy face a chicken-and-egg problem. Technologies either do not yet exist, or they do not exist at a competitive price. Economies of scale, which cut costs and promote more investment in technologies, are hard to achieve because of insufficient demand and the market power of entrenched, carbon-based technologies. Unless government intervenes on the supply side—to promote the innovation that is too risky for private entrepreneurs—and on the demand side—to accelerate creation of mass markets for green sources of energy—private industry cannot get the job done.

Despite all of its free market rhetoric, the U.S. government has developed a sophisticated entrepreneurial apparatus for moving new technologies from the laboratory to the commercial space. These government efforts began in World War II and the Cold War with technologies that had potential military use, but they have now extended across the entire civilian economy. Through the Small Business Innovation Research program, for example, the government gives $2 billion per year to thousands of small firms for the purpose of turning laboratory results into new commercial products. Moreover, as big corporations, under pressure to maximize shareholder value, have reduced their own research efforts, the government has come to the rescue. Thousands of corporate scientists now work to overcome technological barriers, side by side with publicly funded scientists at federal laboratories and at focused university research centers.

These initiatives have produced breakthroughs in industries ranging from biotech to semiconductors—and have also had a major impact in expanding the supply of clean energy technologies. Much of the progress over the last 35 years in bringing down the cost of solar photovoltaic cells can be traced to public-private partnerships sponsored by the Department of Energy as well as the research initiatives pursued at the National Renewable Energy Laboratory. The government has also invested large sums in developing advanced batteries to power electric vehicles and to provide grid storage to balance intermittent energy from wind and solar power. As of this writing, in California alone, there are more than 100 companies that are working to develop more effective forms of energy storage.

While these efforts have been far more successful than most people think, the U.S. system rarely extends to helping firms solve the problems of mass production. The consequence is that the United States has pioneered a series of technologies only to see actual production take off in Asia. This happened with computers and flat panel displays and it might still happen with clean energy technologies. A second weakness of these government efforts is that outside of the military effort, they have focused almost entirely on the supply side and not on the demand side. This is a particular problem because pretty much every clean energy technology—solar power, wind power, new generation biofuels, electric cars, and advanced batteries—has to compete directly with the already installed energy system built on burning fossil fuels. Moreover, a combination of government subsidies and the efficiencies achieved by giant corporations mean that the price points for those incumbent technologies are relatively low. To be sure, if the market prices of coal and petroleum reflected the costs of climate change to the planet, their prices would not be competitive. But Congress has blocked any effort to force fossil fuel prices to reflect their huge environmental externalities.

After the economic collapse of 2008, the Obama administration in 2009 was able to direct billions of stimulus dollars to support clean energy firms. The administration was adamant that the supported firms would produce their products in the United States and reverse the trend of moving manufacturing offshore. But after the Republican victory in the 2010 midterms, the funds dried up and uncertainty rose for clean energy firms.

In wind energy, for example, a generous government subsidy led to a dramatic expansion in the number of wind farms. Wind accounted for 36 percent of all new generating capacity in the nation between 2009 and 2013. But Congress failed to renew the subsidy during most of 2014, so new installations have slowed dramatically. In the case of solar panels, more than 40 U.S. firms failed in 2012 because they could not compete with heavily subsidized Chinese firms. Some of the firms that survived, such as Evergreen Solar, chose to move production facilities to Asia, often because they received additional subsidies and financial support from the Chinese. This process—rational from the perspective of the companies—embarrassed proponents of government help for green energy firms because critics could ask: Why subsidize these firms if they only move to China?

In short, the U.S. has a world-class system for directing scientists and engineers to grapple with the technological challenges of developing clean energy technologies. But there are huge problems in getting those new technologies scaled up quickly enough to meet the challenge of a warming climate. First, we lack a coherent and consistent policy environment that would help these technologies compete against the established carbon energy firms. Subsidies and other forms of government support come and go, so there is no predictable path for clean energy firms. Above all, the government has not been intervening effectively on the demand side to assure firms that there will be strong demand for their products. Second, with this uncertainty, firms face great difficulty raising the patient, private capital that they need to expand their capacity—they generally operate on a tightrope where one mishap is enough to force them into bankruptcy. Finally, decades of neglect of the domestic manufacturing infrastructure and the loopholes in tax law mean that it is a risky gamble for firms to manufacture their products in the United States. But the problem is that when production moves offshore, so does the knowledge required to develop new and better products.

(AP Photo/Charlie Riedel)

In wind energy, generous government subsidy led to a dramatic expansion in the number of wind farms, like this one in Kansas. But Congress failed to renew the subsidy during most of 2014, so new installations have slowed dramatically.

All of these problems could be solved, but the solutions involve more, not less, governmental involvement. Germany, for example, has made the most rapid progress in expanding the role of renewables in its electrical grid. It has done this by very deliberately intervening on the demand side of the energy equation. Germany implemented a system of so-called feed-in tariffs that require the big utility companies to buy renewable energy from households at a price point that made it very attractive for households to install solar panels. At the same time on the supply side, Germany’s state-run development bank has invested heavily in clean energy firms, so that they have the resources to expand their capacity. Germany also has a government-organized system of loan guarantees that facilitates investments in riskier firms that might produce big payoffs in advancing clean energy technologies. And while Chinese cities are still suffering from horrendous air quality, the Chinese government has also made huge interventions on the demand side to accelerate the development of Chinese firms developing clean energy technologies. On the supply side, the Chinese have also used the state investment bank to tilt ever more financing to innovative clean energy firms.

Fortunately, there are examples in the U.S. at the state level of what demand-side policies can accomplish. California has been a leader in imposing “renewable portfolio standards” on electrical utilities. These standards mandate rapid growth in utilities’ use of renewable energy sources. The current rules require utilities to obtain 33 percent of their generating capacity from eligible renewables by 2020. Furthermore, California has also required that utilities expand their capacity for energy storage in recognition that with expanded use of renewables, a stable grid will require cheap storage of electricity. This, in turn, has helped feed the growth of dozens of new firms experimenting with different technologies to find efficient paths to creating grid-based electricity storage.

This means that we already know what policies Washington would pursue if climate policy were no longer held hostage by partisan gridlock, budget paralysis, ideological prejudice, and the power of fossil fuel interests. Since Congress has dithered for so long, it is way too late to imagine that simply raising the price of carbon fuels through taxation or an emission trading scheme will be enough to get the private sector to do the right thing. Certainly, forcing coal and petroleum firms to include environmental externalities in their pricing would help. But the key to an effective policy mix is a serious 20-year energy plan that includes the following key elements:

The Supply Side. We need to redouble the government’s efforts on the supply side by pursuing and supporting the technological breakthroughs that can lead to big cost reductions for renewables and advanced batteries. The creation of ARPA-E in the Department of Energy, which has a mandate to support radical new technologies, is an important step, but such programs need even greater and more secure long-term funding.

The Demand Side. There also has to be a much more significant federal effort on the demand side to assure that companies that are developing these new technologies have a market for their products. Part of this can be done through such policies as renewable portfolio standards and feed-in tariffs, but we also need to make much greater use of the government’s procurement power. The Pentagon has begun to do clean energy retrofits on military bases, but such efforts could be quickly scaled up to strengthen demand both for materials and for firms with the needed expertise. Similarly, a significant chunk of the electrical power grid is managed by federal power authorities and they should be investing heavily in clean energy and smart grid technologies. Every new car and truck purchased by a government agency should be a zero-emission vehicle. Moreover, the federal government could pay a share of the cost for state and local governments to replace their fleets with non-polluting vehicles. It is this kind of assured demand that will encourage existing and new vehicle firms to ramp up production and drive down the cost of clean energy vehicles.

Patient Capital. There need to be new financing mechanisms in place to fund this green energy transition. President Obama has proposed a national infrastructure bank that could mobilize private capital to fund some of the infrastructure improvements that we desperately need. It would make sense to focus such an institution on the clean energy challenge. We know that there are all kinds of energy retrofits, such as trading older light bulbs for energy-efficient ones or adding layers of insulation to drafty buildings, that can pay for themselves in a few years. The national infrastructure bank could fund both these and more ambitious clean energy projects for business firms, nonprofits, and local governments. But an equally important financial task is to create new mechanisms to finance the expansion of the business firms that are scaling up to meet the clean energy challenge. Some of this need could be met by reviving the federal loan guarantee program that the Obama administration used in 2009 and 2010. But we also need to copy what the CIA has done for the last 15 years: The agency has its own venture capital arm—In-Q-Tel—that has made money by supporting firms developing technologies that the agency finds useful. A similar public venture capital initiative to meet the clean energy challenge would not replace private sector efforts, but it could help drive private sector finance in the right direction.

We cannot meet the challenge of zero emissions with our current set of technologies, but if we start right now scaling up our deployment of clean energy while continuing to invest in cutting-edge science, we should be able to generate a series of both incremental and transformative innovations that get us to that goal. What is holding us back is not the technical challenge; it is the misplaced ideological faith in free markets—and the lack of political will.